A question popped up in the forums on "how to identify short covering?" so I thought I'de start a thread on it. Please feel free to share your insights.
We all have our interpretations but this is how I define market participants. I have excluded participants who enter to hedge... as I do now know what category they fit in.
Category 1
Long term buyers and sellers - these participants are looking to profit on a longer time frame basis using daily, weekly, and monthly charts. Usually known as commercials.
Category 2
Medium term buyers and sellers - Although some may prefer to include traders who hold positions for weeks... I prefer to place swing traders in this category. Traders who hold positions anywhere from 1 - 10 days.
Category 3
Short term buyers and sellers - Day traders and scalpers who trade electronically.
Category 4
Floor traders
Okay.. so out of these 4 category, as a day trader I am mainly looking for short covering by participants in category 3 and 4. Why? First Category 1 and 2 do not care about these intraday swings. They are looking on a bigger time frame. However, it would be wrong to completely exclude these groups as they are also day traders when placing a trade. The time I watch for short covering from participants in Category 1 and 2 is when we have a down trend day or we have had several lower value placements during the previous trading sessions.
For example, if the YM hits a daily pivot and declines 30-40pts... I am not watching for short covering by Category 1 and 2 market participants. Their attitude is "who cares?". As a day trader we tend to go "Wow" when the dow rallies or declines 40+ pts. So who are the shorts that will drive the short covering rally? Category 3 and 4 participants. I am mainly concerned about short covering from day traders and floor traders. In other words, those who sold earlier... when will they start covering?
For a short covering to happen the market must be in a decline. Ask yourself who are the traders that shorted at the top and when will they be looking to cover? This can be 30
secs ago, 3 min ago, 30min ago, whatever. The point is understand the psychology of the traders that need to exit in order to profit from this move.
So how do I spot short covering? First, I am a hardcore tape reader. I will remember the 10-lots that appeared on tape on the sell side at the top of the move and look for the same lots appear on the buy side after a decline. You can spot these guys covering on the tape as the tape will start to become green and price decline will slowly come to an end.
So what areas should you watch for? Let's say the markets rallied at the open, formed a double top, and then reversed. Now the shorts from the top or double top.. where will they cover? Perhaps at the 61.8% fibonacci retracement, perhaps at the open, or previous day low, etc... Knowing the reference point is important in my opinion. What I tend to do is to picture myself on the short side and looking for an exit. I ask myself "Where is a good place to exit?" I am sure the majority of the shorts are thinking the same thing. Pick a reference point and stare at tape... you will see all the shorts jumping on the ask to cover, cover, cover!! Short covering fueled rallies are ones I hate the most. It is such an amateur move since everyone is chasing.
Another method I use by looking at volume delta. Basically throughout the decline, I am looking for volume bars that show more contracts being bought at the ask versus sold at the bid. Basically, you will have the early shorts who fear of losing profit covering first. Most of the time price will decline a little further and then you still start seeing the better traders starting to cover. Volume delta shows this clearly as you will start to find more volume bars that show more contracts bought at the ask as price declines. Eventually, most of the shorts will cover and the greedy ones will cover the same time the amateurs start chasing the market.
Its just something that I look for... hopefully traders here can add their input as well. Happy trading.
